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Startup Finance: A VC’s Thoughts on Wash-Out Rounds

One of the more exciting—or excruciating—venture investment scenarios (it depends on whether you tend to focus on clouds or silver linings) is washout financing. This happens when, by way of an example drawn from experience, a company that last raised venture capital at, say, $3.50 a share raises a new round at, say, $0.15 per share. This kind of transaction is pretty straight forward. At least on paper. In practice it is, well, ugly. And, partly as a result of just how ugly, not very common. But, in the event you ever find yourself in a washout scenario, here are some big picture thoughts on the dynamics of these transactions.

In a washout financing, there are, typically, four key sets of players: old management; new management, old investors and new investors. Sometimes, there are managers who belong to both management groups (hybrid managers) and investors who belong to both investor groups (hybrid investors). There are some other less common variations, but let’s leave those for another time.

What makes a washout so challenging is that at the end of the day, some sort of majority of the folks who constitute the old investors and the old management have to agree to a transaction that will essentially “washout” the value of their ownership position in the company. That is, managers and investors who have invested an enormous amount of time, money and sweat in a business must approve a transaction that will reduce the value of their ownership position by perhaps an order of magnitude (the magnitude of the lost value is what separates the washout from the more common and less traumatic “down round” financing). In the process, they have to watch new managers and investors take their baby–however ugly it might be at in current stage–away from them.

Of course, the new investors and managers have a powerful argument when they ask the old management and investors to agree to be washed out. No matter how small, they will argue that something is better than nothing. The logic is powerful; the emotional appeal, less so—particularly at a time when assigning blame for getting to the point where a washout is under consideration at all is what most of the old managers and investors are thinking about.

Assuming you can get the old managers and investors to go along with being washed out, fear of success is, ironically, often a deal killer in a washout scenario. That is, the new investors (and any hybrid investors) have to consider what the (washed out) old managers might do if the new and hybrid investors turn the company around and make a pile of money. In that scenario, old managers have been known to sue the new investors, arguing that old managers were unfairly kicked aside and washed out. Whatever the underlying facts, the old managers often make for jury-friendly plaintiffs, and the new investors often look comfortable in black hats. This kind of suit has now and again been a winner. And even more often, a time, money and PR sink for new investor defendants.

Old investors, of course, could execute a wash out without bringing on board any new investors. When they do, however, the risk of litigation goes up in that the old investors lose an important part of any defense they might have to mount down the road: that independent third parties (the new investors) set the price of the wash out. Thus, as rare as a washout is, it almost always involves at least one new investor. And, the existence of a new investor also helps the old investors justify the new investment to their own investors.

While old investors seldom go it alone in a washout, they often participate in the washout. As hybrid investors, they look to the outside investors as a potential litigation shield, while getting a new piece of the potential upside going forward. Similarly, if per chance (not a very good one) there are any hybrid managers, they, too, will have to get a new piece of the upside. Of course, when you have hybrid investors and/or hybrid managers, the only folks getting the full washout treatment are the old founders/managers–who, as noted, are often in enough of a position to take their ball and go home, and thus kill the deal entirely.

As complex and problematic as washouts generally are, they now and again happen. And sometimes they even work out–for the new investors and new managers. The transaction alluded to at the beginning of this blog was one of those cases. Within 24 months of the washout, the company went public. The new managers and new investors made a great return. The hybrid investors more or less broke even, factoring in their pre-washout investments. As for the old managers, well, at least no one got sued. The new investors and managers must have had good lawyers.